Investing in Bonds: Understanding The Potential Pitfalls

25 January 2018

This article is written by DollarsAndSense

While stocks and bonds are two of the most common types of investments, much of the limelight has always been shone on stocks. This is mainly due to the characteristics of stocks and bonds as asset classes.

Stocks prices tend to be a lot more volatile, with the potential of giving investors either high returns or losses, depending on the performance of the stocks. Bonds on the other hand tend to be labelled as “boring” investments as their prices are more stable and their returns, generally lower. This makes stocks more interesting to investors, and likelier to be reported in the news for its far greater price fluctuations.

Even though bonds are considered less volatile, it does not mean that investors looking for safe investments should blindly put their money into bonds. You still need to understand the characteristics of bonds as an asset class as well as the risks associated with investing in it.

Benefits Of Including Bonds In Your Portfolio

Every asset class has its advantages and disadvantages. Besides allowing you to embark on an asset allocation strategy, bonds offer several other advantages as an investment.

Its main allure lies in preserving investors’ capital and generating regular interest or coupon payments. Regardless of how a company or entity is performing, it has to meet these debt obligations.

What this means for bond investors is that their principal is guaranteed and they are assured of regular coupon payments until the bond matures. At the point of investment, investors will also have superior visibility into their future income flows – when and how much they receive – as well as when the bond will mature.

The risk though is that in the event a company or entity enters serious financial difficulties, bond investors may not get paid for their coupon and could even suffer financial losses on their principal investment. So even though companies are legally obliged to repay you the money they owe, they can only do so if they actually have the financial means to do so.

Although generally less liquid than stock, bonds are also traded. Listed bonds can be bought and sold on the Singapore Exchange (SGX) while others can be traded on Over-The-Counter (OTC) markets. This is a platform where investors buy and sell bonds with registered financial institutions and dealers, rather than trading them with other investors directly.

There are several main risks to watch out for when you consider bond investments. Often investors add bonds into their portfolio for the sake of embarking on an asset allocation strategy and without truly considering the pitfalls of such an investment. Here are five main pitfalls many investors tend to overlook.

#1 Interest Rate Environment

Interest rates movement have one of the biggest impacts on bonds. In fact, its relationship can be viewed as a directly inversed one – when interest rates rise, bond prices generally fall; and when interest rates fall, bond prices generally rise.

There is a simple reason this happens. When interest rates fall, it means that everyone in the economy is generally receiving lower interest returns on their investment. This applies to bond investments as well. And, since bonds pay a fixed coupon, for its yield to fall, its price has to increase. The opposite also applies when interest rates increase.

Bonds aren’t automatically safe. Compare the scenario of two new bonds coming on the market – one issued by Singapore Telecommunications (SingTel) and the other issued by DollarsAndSense.

While both businesses are great (we like flattering ourselves!), people would obviously deduce that SingTel has greater financial muscle to meet its debt obligations. This means that SingTel has greater credit worthiness.

When investing in bonds, you can’t blindly invest. In fact, the recent weak oil and gas market has caused a number of companies within related industries, including Swiber and Ezra, to default on their bonds.

Market conditions and even underperformance by individual companies will result in the company’s credit worthiness declining. Credit worthiness also affects coupon payments. Companies with lower credit worthiness have to offer higher yields on its bonds to attract investors – this just means its existing bond prices will drop to offer a higher yield.

#3 Reinvesting Your Coupons

As bonds only deliver regular coupon payments, investors don’t have the opportunity to compound their growth. This is unlike investing in stocks, which offers investors a chance to grow their wealth through long-term growth in their company.

As such, bond investors must find a way to compound all of the returns they get, every year. The trickiest part about doing this is reinvesting the coupons at the same initial yield. This is because interest rates may cause prices to rise or decline, affecting bond prices and its yields.

#4 Callable Bonds

While some bonds have long maturity periods, investors should check if they have call options on them. What this means is that companies may build in provisions to buy back the bonds after a certain number of years, even before it matures.

This is most likely to happen when interest rates fall. In such scenario, companies would not have to continue paying high yields on their bonds, and can simply re-issue new bonds at lower yields. As a bond investor, you have to read the terms of the bond issue in detail to understand if this provision has been built in.

#5 Long-Term Inflation

Long-term inflation rates affect long-term bonds the greatest. This is because no one truly knows what will happen next year, let alone in 30 years.

Since bonds pay fixed coupons, high inflation will erode your real return. For example, suppose you invest in a 30-year bond paying a coupon rate of 5% per year. After 30 years, you realise that the rate of inflation was actually 10% per annum. This means you were actually losing spending power on your investment rather than growing it.

Continue To Monitor Your Investments

Regularly monitoring your investment performance is the only way to stay on top of your portfolio. Besides rebalancing your portfolio, another key thing to do during this exercise is to evaluate your investment, where you consider if a company’s or the economy’s fundamentals has changed since your last review.

Gradually build your investing knowledge and regularly review your portfolio, however, and you could then start to take advantage of bonds and turn them into a real asset in your portfolio.

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